You are hereA Digression on Comparative Advantage
A Digression on Comparative Advantage
by John Evans
My last article posted on planetpreterist.com, “Biting the Invisible Hand—I,” provoked negative responses from three readers who suggested, among other things, that the principle of comparative advantage (CA), on which economists base their claim that international trade tends to be mutually beneficial to the nations involved, is a dangerous fallacy. My critics also insisted that the preservation in the United States of a free market system that is consistent with Adam Smith’s “invisible hand” requires the existence of a high tariff wall for the protection of American industry. This (to me) glaring demonstration of the lack of understanding of CA and its implications has caused me to alter my writing plans so as to offer the present article before doing a second article on the invisible hand of Adam Smith. I don’t expect to convert my critics, but I hope to prevent some readers from being misled by them.My last article posted on planetpreterist.com, “Biting the Invisible Hand—I,” provoked negative responses from three readers who suggested, among other things, that the principle of comparative advantage (CA), on which economists base their claim that international trade tends to be mutually beneficial to the nations involved, is a dangerous fallacy. My critics also insisted that the preservation in the United States of a free market system that is consistent with Adam Smith’s “invisible hand” requires the existence of a high tariff wall for the protection of American industry. This (to me) glaring demonstration of the lack of understanding of CA and its implications has caused me to alter my writing plans so as to offer the present article before doing a second article on the invisible hand of Adam Smith. I don’t expect to convert my critics, but I hope to prevent some readers from being misled by them.Although I did not refer to CA and international trade in my last article, these topics came up in the ensuing exchange of comments between me and my critics. They informed me that to endorse international trade based on CA inevitably tends to lead to “free trade,” by which they evidently have in mind a world economic system in which goods, services, money, and people move across international boundaries subject to very few restrictions. Such a world, in their view, would be a disaster. I refused to go along with such sentiments and decided to retire from the field with the intention of producing a rebuttal article that will be more widely read, I hope, than additional exchanges of comments would have been. I anticipate that my three advocates of American protectionism will want to again exercise their polemical talents, which are considerable.
I shall begin with the observation that CA is not a philosophical construct like, for example, methodological naturalism, but a material fact. My professional background is economics, not philosophy, and I was far more concerned in my professional life with understanding the world as it is as opposed to developing a system of thought concerned with what it ought to be. One aspect of philosophy is to explore the implications of natural phenomena that are givens; i.e. facts. Therefore, I suppose, to the extent that I advocate the use of CA in helping us decide economic policy, I am engaging in what Robert Heilbroner called “worldly philosophy.”
Although CA is a natural phenomenon, people have had difficulty in constructing a simple definition of it, like, for example, saying that gravity is the attractive force that two bodies of mass exert upon each other. By an accident of history, formal explanations of CA have tended to be confined—unfortunately—to the field of international economics. Economists have used CA to explain why it makes sense for nations to expand their economic activity across international boundaries. This, of course, has aroused the ire of those who, for one reason or another, have been mistrustful of expanding economic contacts with other nations. For convenience, I shall refer to these opponents of expanding such contacts as “protectionists.” I realize that this term is often used pejoratively, and I freely admit that I am using it that way to some extent in this instance. On the other hand, the term is convenient, and I hasten to add that there are sound reasons for sometimes shielding domestic producers from foreign competition. Moreover, because my critics insist on labeling me an advocate of “free trade,” though I am not, I think I am not overstepping the bounds of fair play in identifying them by a term that effectively conveys what they actually do advocate.
The historical context in which CA was revealed to the world began, I believe, with an essay by Robert Torrens in 1815 entitled “Essay on the External Corn Trade.” Torrens, an English military officer and pamphleteer, used this essay to effect an improvement in Adam Smith’s explanation of the gains from international trade. What Smith had taught, boiling it down to simple terms, was that international trade tends to be based upon absolute advantage, by which he meant differences in the quantity of resources, most specifically labor, required to produce given quantities of particular commodities. In Smith’s world, if Poland could produce wheat at a lower cost than England in terms of the labor inputs required to produce a specific quantity of it, net of transportation costs, England would gain economically by importing wheat from Poland and paying for it by exporting to Poland some commodity or commodities in which it had an offsetting absolute advantage.
Torrens had the insight that if England could produce wheat at the same cost as Poland on some of its land, it might still want to import wheat from Poland even though transportation costs might seem to tip the scales in favor of producing the wheat in England. Thus, if England also had a substantial cost advantage over Poland in producing cloth, it would make sense for the English to give up some production of wheat in order to produce cloth for export to Poland in exchange for wheat. Therefore, he concluded, Smith’s concept of absolute advantage did not suffice to explain all international trade. Incidentally, Torrens defined production costs so as to include the inputs of both labor and capital.
Following a long tradition among economists of trying to explain CA at the elementary level by the use of a highly simplified model, I shall inject some numbers into the case presented by Torrens. Suppose that with a certain quantity (X) of labor and capital, England can produce either 100 units of cloth (c) or 100 units of wheat (w), while Poland can produce 40 units of cloth or 100 units of wheat with the same quantity of labor and capital. To simplify, assume zero transportation costs and constant unit costs of production. Using 2X units of resources, 1X for each good, England can produce 100c and 100w, while Poland can produce 40c and 100w. Suppose, however, we let England specialize in cloth and use its 2X units of resources to produce 200c. And let Poland specialize in wheat so that it produces 200w. We now have total production of 200c and 200w, compared to the previous totals of 200c and 140w. Consequently, after England exports some of its cloth to Poland in exchange for wheat, both countries will be able to have more of both commodities than before. Just how such gains from trade would be allocated between the two nations would depend upon what John Stuart Mill called reciprocal demand, which refers to the strength and elasticity of each country’s demand for the other country’s product.
This example obviously employs some highly simplifying assumptions, namely constant production costs, zero transportation costs, homogeneous products, homogeneous resources, uniform technology, and the ability to immediately shift resources from the production of one good to the other without cost. Obviously, none of these assumptions holds in the real world. This, however, does not invalidate CA, though it reduces the benefits from relying on it. Thus, injecting complications that reflect greater realism serves to limit the gains from specializing on the basis of CA without eliminating them.
The applicability of CA to the real world is not restricted to international trade but applies generally whenever resources differ in their relative capabilities. To illustrate this point, here is a slight elaboration of an example that I used when I taught at the University of Alabama. Because I taught there in the days of Bear Bryant and Gene Stallings, it comes from football. Assume that there are two athletes, Q and S, who can each play quarterback or safety with great proficiency. They are close to each other in basic ability, but Q is superior to S at both positions. Now suppose that the head coach calculates that Q is worth 3 points more per game than S at quarterback, but only 1 point more per game at safety. Also assume that a backup quarterback is available who is as good as S at that position, but no one else on the squad can match S as a safety. Our coach should play Q at quarterback and S at safety. He can’t play Q both ways because his performance would then diminish due to fatigue, both physical and mental, and there would be a greater risk of injury. Note that this example demonstrates that specializing on the basis of CA reflects the fact that there are physical limitations to the employment of given quantities of resources. You can’t use only the most productive resources to produce all of the goods and services that are worth producing.
To these examples I shall add another, one that is more complicated but which illustrates more fully CA’s broad applicability and dynamic potential. When I neared retirement and developed enough interest in biblical study to want to accomplish something in that field, I realized that I was at a huge absolute disadvantage compared to any serious biblical scholar in almost any aspect of the study of the Bible. I was getting old, and my ability to memorize biblical passages and retain them had always been rather limited. For example, reading about ten verses of Revelation sufficed to overload my remaining memory neurons and subject me to the reality of rapidly diminishing returns. Yet I observed that the Book of Daniel had been relatively neglected by those biblical scholars whose general theological views I found to be compatible with my own; i.e. those who believed that a New Covenant had been put into place as of AD 70. I also felt that I was able to retain the sense of what I read in Daniel (as opposed to word-for-word recall) with little difficulty, and I felt that I had a pretty good ability to analyze and remember historical data. I concluded, therefore, that if I applied myself to the study of Daniel in concentrated fashion, I might be able, in time, to make a small contribution to overall biblical understanding and that what began as only a CA (and severe absolute disadvantage) might develop in time into an absolute advantage, at least with regard to some parts of Daniel. By the way, I shall be putting out a small book on Daniel 2 later this year and will use this opportunity to shamelessly put in a plug for it. After all, are not economists a materialistic lot whose thinking has been polluted with atheistic notions from such people as David Ricardo, Jeremy Bentham, and John Stuart Mill?
One of the posters of comments to my last article, Windpressor—who is not one my three critics—inserted the following comment from Wikipedia:
“Stanislaw Ulam once challenged Nobel laureate Paul Samuelson to name one theory in all of the social sciences which is both true and nontrivial. Several years later, Samuelson responded with David Ricardo’s theory of comparative advantage: ‘That it is logically true need not be argued before a mathematician; that is not trivial is attested by the thousands of important and intelligent men who have never been able to grasp the doctrine for themselves or to believe it after it was explained to them.’”
I suggest that one of the reasons that “important and intelligent men” have not been able to grasp the nature of CA is that economists have done a lousy job of explaining it to them. Another reason is that its confinement to the arena of international economic theory has turned it into a red flag from the perspective of the bulls of protectionism. Those “bulls” have tended to be easily aroused to fury historically for reasons that are rooted in the widespread development of an “us versus them” mentality. Among those reasons is the belief that “they” have religious views, including atheism, that are subversive of true religious understanding
Although it was Robert Torrens, I believe, who first brought the concept of comparative advantage to public attention, it was the great English economist David Ricardo who receives the credit for popularizing it. Torrens did not use the term “comparative advantage,” and neither did Ricardo; but Ricardo did incorporate a simple mathematical illustration of what he called the principle of “comparative cost” into his Principles of Political Economy, whose first edition appeared in 1817, which quickly came to be viewed as the most authoritative general treatise on economics in existence. In Ricardo’s illustration, two countries, England and Portugal, were assigned different quantities of labor required for the production of two commodities, wine and cloth. If my memory holds, he assumed that it took England 100 labor units to produce a certain quantity of cloth and 120 labor units to produce a certain quantity of wine, while the comparable labor inputs for Portugal were 90 and 80, respectively. He thus assigned Portugal an absolute advantage in both goods, but he gave England a comparative cost advantage in cloth while giving Portugal the comparative cost advantage in wine. Then, using various simplifying assumptions, he concluded correctly that it would be mutually advantageous for England to specialize in the production of cloth and for Portugal to specialize in the production of wine.
Among Ricardo’s simplifying assumptions, he particularly emphasized, as I recall, the immobility of labor internationally. Englishmen could not just get up and move en masse to Portugal. But though they could not emigrate, they could derive some benefit from Portugal’s relatively favorable circumstances by importing those goods in which Portugal had its greatest comparative cost advantages. In effect, therefore, international trade based on comparative costs could be viewed as a substitute for the international immobility of labor.
Although both Smith and Ricardo regarded merchants, bankers, and industrialists as productive agents, the fact that they emphasized labor costs in their discussions of international trade opened the door wide for Karl Marx to develop his infamous labor theory of value (LTV). Marx argued, of course, that labor was the sole source of value in production, which meant that incomes received in other forms than wages were derived from the exploitation of workers. The LTV had great political appeal and, in fact, continues to exert influence among people whose understanding of economics remains at what I shall term the primary school level—which includes many members of the intellectual elite. Above that level, however, it has become generally understood that there are other productive resources than labor and that demand, based on consumer preferences and marginal utility, exercises influence in conjunction with the supply of productive resources in determining market values.
Notwithstanding the intellectual impact of Smith, Ricardo, and other “classical” economists, the forces arrayed against the idea of expanding international trade based on their findings remained powerful in their day and have fought a long, running battle against the dismantling of protectionist barriers that continues to the present time. During the 190 years since the publication of Ricardo’s Principles, the study of international economics has become vastly more sophisticated, and the understanding of the situations in which protectionist measures are justifiable has greatly improved. I have no doubt that there are starry-eyed believers in “globalization” through the expansion of international commercial and financial activity who fit the straw man stereotype that arouses the fears expressed by my three critics, and it is true, as they perceive, that the long-term trend for the world as a whole has tended to be toward greater economic openness internationally. This trend, however, reflects economic reality far more than insidious ideological penetration. Putting it simply, nations that have relied upon CA and adopted relatively open economies have tended to do relatively well economically while nations that have adhered to protectionism have not.
Nevertheless, there are valid protectionist arguments, and I shall briefly call attention to four of them. First, there is the hallowed (and valid) infant industries argument, which holds that it sometimes makes economic sense to encourage the establishment of industries that produce substitutes for previously imported goods until such time as they have gained sufficient proficiency to be able to meet foreign competition. Of course, once you have created a new industry, you have also promoted the rise of a new interest group that will resist efforts to remove the government’s protective umbrella. Unsurprisingly, therefore, the history of efforts to promote economic development through import substitution contains an abundance of economic horror stories in which the “temporary” protection accorded infant industries became permanent.
Closely related to the infant industry is the external economies argument, which holds that the strategic selection of industries that merit protection from imports can result in accelerated economic development by increasing the pool of resources available to other industries. Thus, if a certain nation offers protection from imports to industry E and that industry is subsequently able to develop a sizable pool of skilled labors, managers, and potential entrepreneurs whose talents are transferable to other industries, the economy may be able to gain substantially even if the protection of industry E has to be continued somewhat beyond the infant industry stage. If the external economies prove to be sufficiently great, the national economy will develop comparative advantages in other industries than E that will allow it to substitute for some imports and expand exports.
The external economies argument is a challenging one to implement, of course, and it is necessary to keep in mind that there are external diseconomies as well as external economies. An example of an external diseconomy is when a firm dumps toxic waste into a stream without having to pay for the privilege of doing so. The costs that it thereby imposes on others are external to the profit and loss calculations of the firm’s managers and are likely to be ignored by them unless they have reason to fear that punitive action will be taken against them.
It is obvious that estimating external economies and diseconomies is a very complex matter and that the estimation process can be (and will be) abused. For example, it is my belief that the claims that global warming is currently taking place and has been doing so for some time now exaggerate its extent and also exaggerate the degree that it is caused by human activity. I believe that the exaggeration occurs, in part, because environmentalism has become a kind of secular religion—to some extent a replacement for Marxism—in which the emotional need to worship something trumps the material evidence. Some readers may not agree with me, and perhaps they are right, but consider the damage that is likely to be done to the world economy if I am right. My point is simply that externalities are dangerous things to deal with in forming public policy. It is because of this fact that libertarian economists have tended to take the position that since externalities cannot readily be incorporated into market calculations, they should be ignored in the formation of public policy unless they can be converted into internal costs and benefits. This conversion can be done, for example, with such measures as pollution taxes (as opposed to prohibitions) and subsidies for the training of skilled workers. Clearly, however, the opportunities for political mischief making abound once the recognition of externalities becomes a major feature of public policymaking.
A third argument for protection is that the costs of shifting resources from some industries to others may prove to be so substantial as to nullify the potential gains from specializing on the basis of CA. Thus, if a nation eliminates some of its barriers to imports with the expectation that the workers who become unemployed as a result will find employment elsewhere and that its exports will increase in accordance with CA, it could happen that the discounted present value of the losses to the economy caused by the rise in unemployment exceeds the discounted present value of the gains achieved even if the losses are relatively short-term and the gains are permanent. Moreover, there may be alterations in the distribution of income associated with trade liberalization that could warrant the adoption of a go-slow approach to liberalization. Thus, if some workers are permanently injured economically because of liberalization and others gain, the difficulty of making interpersonal comparisons raises questions about whether there are gains to the nation as a whole. Economists have sometimes suggested that this consideration warrants the granting of some compensation to those who suffer permanent injury as a consequence of trade liberalization.
The mention of distributional considerations as a factor to be taken into account in framing trade policy reminds me to point out that expanded international trade may tend to cause broad changes in income distribution even if no one suffers an absolute income decline after the adjustments to increased trade are completed. If, for example, the United States expands its imports of goods that are produced by relatively labor-intensive methods in this country, it is conceivable that the net result in terms of income distribution will tend to be a decline in the relative position of workers on the relatively low end of workers’ pay scales even though these workers do not experience an absolute decline in their incomes. On the other hand, if the “gravitational pull” of the U.S. economy results in the increased immigration of low-skilled workers into the United States, as opposed to the increased importation of goods produced by them, the impact upon the incomes of some American workers is likely to be decidedly more negative.
Staunch protectionists tend to oppose both an increase of imports of goods from such low-wage countries as China and Mexico and the immigration into the United States of low-skilled workers from such countries. In my judgment, any adverse distributional effects resulting from increased imports are likely to be far less than those resulting from the increased immigration of relatively unskilled workers. And that is without taking into account the social effects of absorbing large numbers of such immigrants, particularly those whose religious and/or political views conflict with the system of government established by the U.S. Constitution.
That the United States can insulate itself from the reality of low income levels in much of the world is an idea whose soundness I profoundly doubt. For me, the ideal way to deal with the pressures resulting from the vast differences in income levels around the world is the adoption of the invisible hand approach to economic organization in as much of the world as possible, by which I mean having national economies with free markets and the appropriate institutional structures to allow them to function smoothly. I also am firmly of the belief that the process of achieving such an outcome is immeasurably improved to the extent that financial capital and technological know-how are allowed to move.
My critics seem to oppose such international mobility of capital out of fear that when U.S. firms set up operations in foreign countries, they do so at the expense of the U.S. economy; i.e. they “export jobs.” Somehow, nevertheless, the United States seems to be able to achieve real economic growth at a relatively high rate for such a high-income nation and to do so with a relatively low unemployment rate. It is fitting, I think, to point out that the United States is a huge net importer of financial capital from the rest of the world; and we are, in fact, the world’s largest debtor nation. Total private saving in the United States is insufficient to finance our existing level of private investment. Consequently, we import savings from the rest of the world by giving foreign investors huge financial claims on us and encouraging them to invest here. That, incidentally, allows us to raise the American standard of living by importing substantially more goods and services from foreigners than we export to them. Under these circumstances, I don’t think it makes much economic sense to object when some U.S. firms engage in business operations in foreign countries. I do hope, however, that some Christian missionaries are allowed to go there also and that our government pushes the idea of openness beyond mere economic considerations.
Oh yes, I wrote earlier that I would present four valid arguments for protection, and I have only presented three. The fourth argument is protection for national defense reasons. Putting it simply, if the Chinese have a potential CA in the production of rockets that can be used to destroy communication satellites in space, I do not think we should give up the production of such rockets in order to import them from China! Enough said.
I shall close this article by returning to the theme that economists have done a lousy job of explaining CA to the public. In preparing this article, I spent a few minutes surfing the Net for a good illustration of this point and quickly came across a remarkably suitable example of what I mean that was authored a few years ago by Paul Krugman, the well-known Princeton economist and New York Times hatchet man, or should I say columnist? Its title, “Ricardo’s Difficult Idea,” was inspired by Daniel Dennett’s Darwin’s Dangerous Idea: Evolution and the Meanings of Life (1995), which I have not read but have read about. Krugman evidently found Dennett’s work to be inspirational, for he begins his article on CA with the statement that “The idea of comparative advantage—with its implication that trade between two nations normally raises the real incomes of both—is, like evolution via natural selection, a concept that seems simple and compelling to those who understand it”; i.e. those intellectuals who, like Krugman, do not have an aversion to mathematical models. Krugman proceeds to demonstrate the breadth of his knowledge by recognizing that the resistance to accepting the validity of CA is different from the resistance to the acceptance of Darwinism. In the case of CA, he finds that it has tended to be rejected by some people “who do value ideas, but somehow find this particular idea impossible to grasp.” In the case of Darwinism, however, the problem is that the resistance comes from “people who simply dislike the idea of ideas” and whose blind opposition reflects “the persistence of creationism.” Much later in his article, he brings Darwin back and refers to Richard Dawkins, the prominent evolutionary biologist and militant atheist, as the type of popularizer for Darwinism that economics has needed for CA.
Personally, I find the idea of comparing CA to Darwinism to be ludicrous, and it is clearly not a move that is calculated to win over adherents of protectionism to the idea that CA is a valid concept that ought to have some influence over the formation of public policy. For people like Krugman, however, such people are hopeless, and the problems that they cause will ultimately be resolved by eliminating their influence on the making of public policy, no doubt via Darwinian evolution. At no point, incidentally, does Krugman point out that CA has broader applications than to international economics. Thanks a lot, Krugman, and so much for the notion that the enemy of my “enemy” is my friend.
Steven M. Suranovic has written a series of good articles on international economics for the Net. On Torrens, see http://internationalecon.com/v.1.0/ch40/40c00a.html.
“Ricardo’s Difficult Idea,” http://web.mit.edu/krugman/www/ricardo.htm.